A good friend texted me the other day. The market was down and he was nervous. “Is this the correction? He asked. My answer, which never changes every time he asks, was simple. “I don’t know. Stick to your investment plan.”
Study after study shows that investor behavior causes a lot of damage to a portfolio. Good intentions aside, investors pile up in stocks when the market hits new highs. When it falls, they jump off the ship. The result is a repeated cycle of buying high and selling low.
Investor returns suffer as a result. Like this Morningstar Report shows that real returns for investors are lower than for mutual funds due to poor market timing. Carl Richards calls it the behavior gap.
There are ways to “Mind the Gap”. The main one is to recognize the problem. We are all the more likely to avoid adverse investment behavior as we understand it. Selling out of fear as the market goes down produces suboptimal returns. At a minimum, we should consider this fact before executing a trade out of fear.
Beyond recognizing the problem, however, we can change our mindset. Falling stock prices, like falling prices for anything we buy, allow our money to flow further. We are delighted when the price of gasoline goes down. We are often less optimistic about falling stock prices. Yet the decline in the stock market offers several key benefits to any portfolio.
Here are five of them.
1. Monthly contributions Buy more shares
As you contribute each month to 401 (k), IRA, or taxable accounts, your money goes further. Even if the contributions remain the same, falling stock prices lead to the purchase of more stocks. It’s worth looking at your accounts to see this in action.
2. Reinvested dividends go further
Dividends can represent a significant portion of an investor’s returns. According to a studyFrom 1802 to 2002, dividends contributed five percentage points to the 7.9% total return on stocks. The reinvestment of dividends is the key to these results.
According to analysis, dividend reinvestment has accounted for nearly 95% of the S&P 500’s compound returns since 1926:
A $ 10,000 investment in the S&P 500 Index at its inception in 1926 (Figure 2) with all dividends reinvested would have reached at the end of September 2007 approximately $ 33,100,000 (10.4% compounds). [Using the S&P 90 Stock Index before the 1957 debut of the S&P 500.] If the dividends had not been reinvested, the value of that investment would have been just over $ 1,200,000 (6.1% compounded) – an astounding difference of $ 32 million.
Falling stock prices help amplify the effect of reinvested dividends. At lower prices, reinvested dividends buy more shares of a company, fund or ETF.
3. Share buybacks generate more value
For the same reason that lower prices benefit reassessments and reinvestment of dividends, lower prices also benefit corporate buyout programs. According to a WSJ Report, companies repurchased $ 338.4 billion of shares in the first half of this year. As a company’s stock price falls, the money spent on buybacks will buy more shares.
4. Rebalancing allows you to sell high and buy low
A fourth benefit of a falling market is an opportunity to sell high and buy low through rebalancing. Rebalancing, by definition, is selling assets that have increased in value and using the proceeds to buy assets that have lost value.
When stock prices fall, rebalancing usually involves selling bond funds and using the proceeds to buy equity funds. The simple rebalancing step results in increased risk-adjusted returns, in some cases improving results by 21%.
5. Opportunity to gain invaluable investment experience
Finally, a declining market offers investors invaluable experience. Many investors manage a portfolio for decades. Experiencing a significant drop in the market offers a first-line opportunity to understand exactly how you are going to deal with your emotions. This in turn can inform future investment plans and expectations.
This all brings me back to my friend’s question. Is this the correction?
I do not know. Stick to your investment plan.